Welfare economics Recall, the allocation of resources refers to:

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0In this chapter, look for the answers to these questions:What is consumer surplus? How is it related to the demand curve?What is producer surplus? How is it related to the supply curve?Do markets produce a desirable allocation of resources? Or could the market outcome be improved upon?CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

1Welfare economics Recall, the allocation of resources refers to:how much of each good is producedwhich producers produce itwhich consumers consume itWelfare economics: the study of how the allocation of resources affects economic well-beingFirst, we look at the well-being of consumers.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

2Willingness to Pay (WTP)A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good.WTP measures how much the buyer values the good.nameWTPAnthony$250Chad175Flea300John125Example: 4 buyers’ WTP for an iPodCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

3WTP and the Demand CurveQ: If price of iPod is $200, who will buy an iPod, and what is quantity demanded?A: Anthony & Flea will buy an iPod, Chad & John will not.Hence, Qd = 2 when P = $200.nameWTPAnthony$250Chad175Flea300John125CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

6About the Staircase Shape…This D curve looks like a staircase with 4 steps – one per buyer.If there were a huge # of buyers, as in a competitive market,there would be a huge # of very tiny steps,and it would look more like a smooth curve.QCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

7WTP and the Demand CurveAt any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher.Flea’s WTPAnthony’s WTPChad’s WTPJohn’s WTPQCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

17Cost and the Supply CurveCost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).Includes cost of all resources used to produce good, including value of the seller’s time.Example: Costs of 3 sellers in the lawn-cutting business.A seller will only produce and sell the good if the price exceeds his or her cost.Hence, cost is a measure of willingness to sell.namecostAngelo$10Hunter20Kitty35CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

20Cost and the Supply CurveAt each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower.Kitty’s costHunter’s costAngelo’s costQCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

28What Do CS, PS, and Total Surplus Measure?CS = (value to buyers) – (amount paid by buyers)CS measures the benefit buyers receive from participating in the market.PS = (amount received by sellers) – (cost to sellers)PS measures the benefit sellers receive from participating in the market.Total surplus = CS + PSTS measures the total gains from trade in a market.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

29The Market’s Allocation of ResourcesIn a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off?To answer this, we use total surplus as a measure of society’s well-being.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

31Efficiency Total surplus = (value to buyers) – (cost to sellers)An allocation of resources is efficient if it maximizes total surplus. Efficiency means:Raising or lowering the quantity of a good would not increase total surplus.The goods are being produced by the producers with lowest cost.The goods are being consumed by the buyers who value them most highly.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

32Efficiency Total surplus = (value to buyers) – (cost to sellers)Efficiency means making the pie as big as possible.In contrast, equity refers to whether the pie is divided fairly.What’s “fair” is subjective, harder to evaluate.Hence, we focus on efficiency as the goal, even though policymakers in the real world usually care about equity, too.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

34Which Buyers Get to Consume the Good?Every buyer whose WTP is ≥ $30 will buy.Every buyer whose WTP is < $30 will not.So, the buyers who value the good most highly are the ones who consume it.PQDSCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

36Does Eq’m Q Maximize Total Surplus?At Q = 20, cost of producing the marginal unit is $35value to consumers of the marginal unit is only $20Hence, can increase total surplus by reducing Q.This is true at any Q greater than 15.PQDSCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

37Does Eq’m Q Maximize Total Surplus?At Q = 10, cost of producing the marginal unit is $25value to consumers of the marginal unit is $40Hence, can increase total surplus by increasing Q.This is true at any Q less than 15.PQDSCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

38Evaluating the Market Eq’m: SummaryThe market eq’m is efficient:The eq’m Q maximizes total surplus.The goods are produced by the producers with lowest cost,and consumed by the buyers who value them most highly.The govt cannot improve on the market outcome.Laissez faire (French for “allow them to do”): the govt should not interfere with the market.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

39Why Non-Market Allocations Are Usually BadSuppose the allocation of resources were instead determined by a central planner (e.g., the Communist leaders of the former Soviet Union.)To choose an efficient allocation, the planner would need to know every seller’s cost and every buyer’s WTP, for each of the thousands of goods produced in the economy.This is practically impossible, so centrally planned economies are never very efficient.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

40Adam Smith and the Invisible HandPassages from The Wealth of Nations, 1776“Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only.He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them…It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest….Adam Smith,CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

41Adam Smith and the Invisible HandPassages from The Wealth of Nations, 1776“Every individual…neither intends to promote the public interest, nor knows how much he is promoting it….He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.an invisible handNor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”Adam Smith,CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

42CONCLUSIONThis chapter used welfare economics to demonstrate one of the Ten Principles: Markets are usually a good way to organize economic activity.But we assumed markets are perfectly competitive.In the real world, sometimes there are market failures, when unregulated markets fail to allocate resources efficiently. Causes:market power – a single buyer or seller can influence the market price, e.g. monopolyexternalities – side effects of transactions, e.g. pollutionCHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

43CONCLUSIONWhen markets fail, public policy may remedy the problem and increase efficiency.Welfare economics sheds light on market failures and govt policies.Despite the possibility of market failure, the assumptions in this chapter work well in many markets, and the invisible hand remains extremely important.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

44CHAPTER SUMMARYThe height of the D curve reflects the value of the good to buyers—their willingness to pay for it.Consumer surplus is the difference between what buyers are willing to pay for a good and what they actually pay.On the graph, consumer surplus is the area between P and the D curve.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

45CHAPTER SUMMARYThe height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if the price they get is at least as high as their cost.Producer surplus is the difference between what sellers receive for a good and their cost of producing it.On the graph, producer surplus is the area between P and the S curve.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

46CHAPTER SUMMARYTo measure of society’s well-being, we use total surplus, the sum of consumer and producer surplus.Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them.Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus.CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS